UK competitiveness after Brexit

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On June 23, 2016, the United Kingdom voted to leave the European Union. At the time of writing, Article 50 of the Lisbon Treaty—which governs the withdrawal of a member state from the Union—had not yet been triggered and a timeline for the exit process had not been fixed. Nevertheless, economic repercussions of the vote are already being felt and will probably be amplified once actual treaty changes are implemented (note that the data for the GCI were collected before the vote and thus do not yet reflect the new situation). Before the Brexit vote, the economic recovery in Europe was progressing; this progress was backed by stronger internal demand fueled by low oil prices, accommodating monetary policy, and ongoing job creation. The vote triggered an immediate depreciation of the British pound and a drop in the price of UK and euro-area risky assets, and has led to downward corrections of the short- to medium-term growth outlook for the United Kingdom as well as the rest of the European Union.1

Although we do not know yet what the exact impact of Brexit will be, economic repercussions of the leave vote are likely to fall into two categories: in the short run, before any modifications of the legal framework have taken place, economic outcomes are affected by an increase in uncertainty over the legal conditions that will eventually prevail. This increased uncertainty has macroeconomic consequences, reducing investment, consumption, and foreign trade as consumers and investors become more cautious. Projections by the European Commission yield a downward revision of the 2017 growth forecast by 1.00 to 2.75 percentage points for the United Kingdom and 0.25 to 0.50 percentage points for the European Union (the range reflects different assumptions about the change in the risk premium that captures the severity of the shock).2 All scenarios assume a 15 percent depreciation of the pound, which should improve UK export performance; nevertheless, the net effect on growth is predicted to be negative. Because uncertainty is holding back investment and reducing the attractiveness of the United Kingdom for talent (both students and workers), important drivers of competitiveness are expected to be affected by the leave vote before any treaty changes have taken place.

In the longer run, economic repercussions will be emanating from changes to the four freedoms guaranteed by the European Union (the free movement of people, goods, services, and capital) as well as the partial or full withdrawal of the United Kingdom from the EU budget. The key long-run channels through which the exit will be transmitted are thus increases in the cost of trade, investment, and movement of labor, which will all eventually be reflected in the goods and labor market efficiency as well as market size pillars of the Global Competitiveness Index (GCI). Most projections have focused on the immediate trade and investment effects of Brexit. The three most plausible scenarios for governing the United Kingdom’s economic relations with the European Union post-Brexit are (1) to adopt European Economic Area (EEA) membership following the Norwegian model (the most liberal option in terms of the four freedoms), (2) to adopt European Free Trade Association (EFTA) membership following the Swiss model, or (3) to fall back on World Trade Organization (WTO) rules. There is a consensus among leading economists that the impact on GDP will be negative under all scenarios that reduce any or all of the four freedoms. The largest negative impact—of –6.3 to –9.5 percent of UK GDP (in 2030)—is predicted under a scenario that models impacts on trade, productivity, and budget with EEA/EFTA parameters in a dynamic setting.3 Static, trade-only projections by the same authors put the economic cost at 1.3 to 2.6 percent of 2030 GDP for the United Kingdom.4 UK government projections assume changes in budget, trade, foreign direct investment, and productivity and find losses for the UK economy ranging from 3.8 percent (under the EEA/Norwegian model) to 7.5 percent (using the WTO model) of GDP in 2030.5 Since geographic proximity is an important factor in determining trade flows, simply shifting trade to other (necessarily more distant) markets is unlikely to provide a quick fix.6

Additional effects on growth and competitiveness are likely to be felt in terms of innovation impact if the country becomes less accessible for international talent. In order to cushion the impact of the withdrawal of EU funding for basic research, the UK Treasury has pledged to guarantee funding for projects that are currently funded by the EU.7

Although the majority of those mechanisms contribute to weakening the UK economy, one source of potential benefits of leaving might be regulatory changes that shift the regime in a way that is optimal for the United Kingdom; currently, a significant part of the UK economy is subject to a regulatory regime that reflects a compromise between the preferences of 28 countries. However, no clear plan for such regulatory changes that would allow for a forecast of economic impact has been outlined.

Although it is clear that various drivers of competitiveness will be affected by the leave vote, the size of the ultimate effect of Brexit on productivity itself remains difficult to predict. Reversing trade liberalization is known to have negative productivity effects because it loosens competitive pressures, giving more leeway to less-productive firms. The ultimate productivity impact will depend to a large extent on the level of competition that prevails in the UK economy after Brexit.

A distributional analysis of the longer-term consequences of Brexit suggests that the costs will mostly fall on those with middle incomes, although the poor will not be spared from its impact.8